Understanding the Federal Debt Limit

January 30, 2006

Federal
borrowing has once again reached the statutory debt limit. Treasury Secretary John W. Snow notified
Congressional leaders that he has begun taking actions to avoid breeching the
debt limit and warned that "Given current projections, it is imperative
that Congress take action to increase the debt limit by mid-March.”[1] This brief answers common questions about the
statutory debt limit and the need to increase it.

What is the debt limit and why is it important? Since 1941, Congress has established in law the
maximum amount of debt the federal government may issue. The Treasury does not
have legal authority to issue any debt above this statutory limit. To
avert a default on its credit obligations or a shutdown of government
operations, occasionally it is necessary to raise the limit. The current
statutory debt limit, $8.18 trillion, was established in November 2004.

Figure 1. Raising the Debt Limit

Date

Debt Limit

August 1997

$5.95 trillion

June 2002

$6.40 trillion

May 2003

$7.38 trillion

November 2004

$8.18 trillion

Debt subject to limit has two components: (1) debt
held by the public (debt held by any individual or entity that is not the
federal government such as a mutual fund, individual investor, foreign
government, or a municipal government) and (2) intragovernmental debt (debt the
government owes itself such as the Social Security Trust Funds, the Medicare
Hospital Insurance Trust Fund, and the Civil Service Retirement and Disability
Fund).

Debt held by the public. When revenues received by the Treasury are not
sufficient to meet the expenses of the federal government, the Treasury borrows
to obtain the cash necessary to meet its obligations. Although much of the federal
revenue used to finance government operations is received in the spring when
individuals file their annual income tax returns, the federal government incurs
a steady stream of operating costs all year long. Consequently, to smooth cash
flow and enable the federal government to finance daily operations, the
Treasury borrows money by selling securities to the public. These securities
comprise the debt held by the public. Debt held by the public rises and falls depending on
the government’s immediate borrowing needs. It represents the cumulative amount
of borrowing required to finance budget deficits. Because debt held by the
public flows through financial markets, it has more immediate relevance to the
economy than intragovernmental debt, which is a matter of internal bookkeeping.
As of January 26, 2006 debt held by the public totaled $4.7 trillion.

Intragovernmental debt. For the most part, intragovernmental debt consists
of trust fund accounts that are credited with dedicated revenue such as Social
Security and Medicare payroll taxes (FICA). In theory, surpluses in these
accounts are “saved” for future benefit
obligations. As of January 26, 2006 intragovernmental debt totaled $3.4
trillion.

This debt increases automatically every year by the
amount of trust fund surpluses invested in Treasury securities, regardless of whether the
budget is in surplus or in deficit. For
example, in every year since 1984 the Social Security program has generated a
surplus – the federal government has collected more payroll taxes than it
needed to pay current benefits. Surplus payroll taxes are held by the Social
Security Trust Fund in the form of special obligation bonds. In addition, the
trust fund is credited with interest on its balance in the form of additional
bonds. As Social Security surpluses grow, so too does the Social Security Trust
Fund, and intragovernmental debt rises. Thus, unlike debt held by the public,
growth of intragovernmental debt does not reflect an imbalance in short-term
fiscal policy. It represents a very different problem ¾ growing long-term obligations that future taxpayers
will have to pay for when the Treasury ultimately has to transform these bonds
into benefits.

What is driving the need to raise the debt limit? Unchecked growth in either category of debt will generate
pressure to raise the debt limit. In FY 2006, the Congressional Budget Office
(CBO) estimates that total debt will go up by $610 billion. Of that, $333
billion (55 percent) is attributable to an increase in debt held by the public
and $277 billion (45 percent) is attributable to an increase in intragovernmental
debt.[2]

To understand the role of each component relative to
the debt limit, consider the brief period in 1998-2001 when four years of budget
surpluses allowed the federal government to buy back, or “pay down,” $453
billion in debt held by the public. Over those same four years,
intragovernmental debt increased by $853 billion (largely due to substantial Social
Security surpluses credited to the Social Security Trust Fund). As a result, the total debt subject to limit rose from $5.3
trillion in 1997 to $5.7 trillion at the end of FY 2001.

When Congress increased the debt limit in
2002 from $5.95 trillion to $6.4 trillion, debt held by the public was actually
lower than it had been when the debt limit was previously increased in
1997. The limit was raised to accommodate the increase in intragovernmental
debt.

Congress could avoid future trust fund-induced
increases in the debt limit if it “saved” trust fund surpluses by running
total, or “unified,” budget surpluses equal to the trust fund surpluses and making
corresponding reductions in debt held by the public. If the increase in intragovernmental
debt, which mostly represents future obligations, were offset by an equivalent
reduction in debt held by the public, the budget and the economy would be
better prepared to make good on those future obligations.[3] Following this strategy, however, would
require substantial budget surpluses and a degree of political cooperation and fiscal
discipline that is not currently in evidence.

Does setting a tight debt
limit provide an effective check on fiscal policy? Raising the debt limit
is essentially a decision to pay the bills. Unlike the now expired budget
enforcement mechanisms such as statutory spending caps or the pay-as-you-go (PAYGO)
rule for entitlement expansions and tax cuts, the debt limit places no
restrictions on specific tax and spending decisions. If deficits result from
these policy decisions, or if the economy fails to grow as projected, the debt limit
must be increased to prevent a default on the government’s obligations.

However, the need to raise the
debt limit does provide an opportunity to assess past fiscal decisions and, if
necessary, make course corrections. In the past, major increases in the debt
limit have often been accompanied by the enactment of deficit reduction plans
such as the November 1990 increase of $915 billion, the August 1993 increase of
$530 billion, and the August 1997 increase of $450 billion. In the absence of
such linkage Congress has been reluctant to raise the debt limit by more than is
necessary to get through a short period of time. Thus, while the debt limit is
not, by itself, a fiscal firewall, in the absence of other more effective
mechanisms such as spending caps and PAYGO, it is one of the few budgetary
speed bumps left to provide a sense of fiscal discipline.

What is the status of
Congressional legislation raising the debt limit? When the House adopted
the conference report for the 2006 budget resolution (H. Con. Res. 95), it
triggered House Rule XXVII (also known as the “Gephardt Rule”). The rule
automatically produced a joint resolution (H.J.Res. 47) raising the debt limit
to $8.961 trillion (an increase of $781 billion). The resolution, according to
the rule, was “deemed” passed and then sent to the Senate as a separate measure
in May 2005. To date the Senate has taken no action.

In his letter to Congress, Secretary Snow stated that even if Treasury
takes “all available prudent and legal actions to avoid breaching” that limit,
“we anticipate that we can finance government operations no longer than
mid-March.”[4] For this reason, Congress will be forced to
make the debt limit an agenda item soon after it reconvenes in late
January.

In the wake of Congressional inaction, what are the options
the Treasury has to avoid breaching the debt limit?The U.S. Treasury can
employ a few financial maneuvers to avoid breaching the debt limit and
defaulting on the national debt. These transactions are benign and completely
legal, but in the wake of the corporate accounting scandals in 2002 they are a
source of unease among lawmakers and the public. Moreover, all of these
machinations merely postpone the inevitable – an increase in the statutory debt
limit.

Specifically, the Treasury can:

Suspend reinvestment
of government securities in federal trust funds such as the G-Fund of the
federal employee’s Thrift Saving Plan (TSP) or the Civil Service Retirement and
Disability Fund (CSRDF). Such action
prevents this part of the intragovernmental debt from growing. Manipulating
retirement funds may sound ominous, especially to federal employees, but laws
enacted in the 1980s require the Treasury to restore all due interest and
principal to the fund as soon as it can.

Delay or suspend the
auction of public debt instruments. This
action prevents debt held by the public from growing. Individuals and
institutional investors regularly purchase Treasury securities for investment
purposes. The revenue from the sale of securities is then used to manage the
cash flow needs of the federal government. Therefore, suspending the sale of
T-bills can be very disruptive to domestic and international financial markets
as well as the operations of the federal government.

Has the Treasury resorted to similar tactics before? Yes. The Clinton Administration undertook similar
measures in 1995 and 1996, and the Bush Administration resorted to such tactics
in 2004, 2003 and twice in 2002. Now Treasury finds itself again in
familiar territory as it seeks to avoid default while it waits for
Congressional action.

How did we get to this
point? In the spring of 2005, debt
subject to limit was $7.718 trillion – $467 billion below the statutory debt
limit. Recognizing the likelihood that it would need to raise the debt limit in
the not-too-distant future, Congress included provisions in the FY 2006 budget
resolution to raise the debt limit by $781 billion to $8.965 trillion. Because
raising the debt limit is a political “hot potato” – a vote that many
legislators seek to avoid – the budget resolution contained special procedures
and protections to expedite action on the debt limit and minimize the political
risk in approving the increase. However, the different procedures for
increasing the debt limit in the House and Senate – and the desire by both
chambers to avoid such a vote – put the two chambers at odds with each other.

When the House passed the FY 2006
budget resolution, the Gephardt Rule allowed the House to pass a separate
increase in the debt limit without a recorded vote (legislation increasing the debt limit was
“deemed” passed with passage of the budget resolution). The conference report
for the budget resolution also contained reconciliation instructions directing
the Senate Finance Committee to report a reconciliation bill that would provide
for a $781 billion increase in the debt limit to $8.965 trillion.[5]

Thus, the Senate now has two
ways to deal with the debt limit issue. It could pass its own standalone
legislation under the protection of reconciliation, which the House must then
approve by recorded vote – a scenario House leaders would prefer to avoid. Alternatively, the Senate could
take up the House-deemed legislation under regular order without reconciliation
protections – subjecting the legislation to amendments (including politically
motivated amendments as well as amendments to impose budget controls) and
damaging extended debate – a scenario Senate leaders would prefer to avoid.

Simply phrased, lawmakers’ aversion to a debate and a
recorded vote raising the debt limit has created a procedural stalemate that,
to date, neither chamber has been eager to break. Adding to the
stalemate over the debt limit was a late summer surge in federal tax revenue
that reduced estimates of the FY 2005 deficit. A statement from Treasury
officials in August 2005 said that the Department was “reasonably confident
that the debt limit will not be reached in 2005,” but rather during the first
quarter of calendar year 2006.[6]
With the pressure off, Congress turned its attention to other matters.

If the past is a guide, Senate leaders may stall until mid-March and then
bring up the House-deemed debt limit increase. At that time, Treasury will have
exhausted nearly all its cash management options and Congress will be eager to
adjourn for a planned recess. This combination of events could effectively
preclude any opportunity for lengthy debate or amendments and ensure swift
passage of an increase in the debt limit. This scenario is remarkably similar
to what the Senate did in 2003.

What should Congress do? Political leaders must rise above partisan gamesmanship
and increase the debt limit to avoid a damaging and unnecessary debt crisis. Approval of a
debt limit increase is necessary to maintain the full faith and credit of the
United States government. Failure to approve an increase would have dire
consequences for government finances and financial markets. Delaying action on an increase until the
last possible moment, forcing Treasury to utilize extraordinary measures to
avoid a default, is unnecessary and irresponsible.

However, with budget deficits projected for “as far as
the eye can see,” The Concord Coalition believes that no large scale increase
in the debt limit should be approved until Congress and the President agree on
a new plan to restore fiscal discipline. In December, bipartisan leaders of The
Concord Coalition called on Congress and the President to develop a specific
and realistic plan to put the country on a sustainable long term fiscal path
and reinstate discretionary spending caps and PAYGO rules for both entitlement
expansions and tax cuts.7 The rationale for this trade-off is clear: greater
flexibility to increase the debt is allowed, but only within the context of a
fiscally responsible budgetary framework.

The Concord Coalition also believes that
both the House and Senate should debate and vote on the debt limit. If Members
of Congress find it embarrassing or distasteful to vote on a debt limit
increase, the remedy is to enact more responsible fiscal policies.

[1]
Letter to
The Honorable Bill Frist, Majority Leader US Senate, February 16, 2006Letter
to The Honorable Mitch McConnell, Majority Whip, US Senate, December 29, 2005.

[3] As explained by the Office of
Management and Budget (OMB): “From an economic standpoint, the Government is
able to prefund benefits only by increasing saving and investment in the
economy as a whole. This can be fully accomplished only by simultaneously
running trust fund surpluses equal to the actuarial present value of the
accumulating benefits and not allowing the federal fund deficit to increase, so
that the trust fund surplus reduces a unified budget deficit or increases a
unified surplus. This would reduce Federal borrowing by the amount of the trust
funds surplus and increase the amount of national saving available to finance
investment. Greater investment would increase future incomes and wealth, which
would provide more real economic resources to support the benefits.” FY 2006
Budget of the U.S., Analytical Perspectives, p.375.